Understanding how blockchain technology operates is important for crypto enthusiasts, now that the market is in a downturn, and multiple projects are having trouble keeping their infrastructure working smoothly.
You’ve probably heard about the Terra blockchain being halted recently, on the back of massive crypto liquidations. Such events can trap crypto users off-guard and more often than not, the reason is the lack of education. To provide a helping hand for beginners, this material will explain simply how a blockchain can operate.
In the traditional banking system, centralization is the key concept making the industry operate. All financial transactions are being conducted on a system created and managed by the bank. When an account spends money another receives the equivalent amount, or vice-versa, and all these changes are done by banks.
At the same time, central banks have control over the monetary supply, by increasing/lowering interest rates, buying financial assets, and extending short-term loans to solvent financial institutions.
Blockchain technology, on the other hand, brings forward decentralization, removing the need for banks or other financial instructions, making the system more affordable and accessible for those that don’t already have access to such services.
In this case, all the information on the ledger (a.k.a. blockchain) is not kept in a single place, but multiple locations. As financial transactions occur, cryptocurrencies are moved from one address to another, a process that involves the creation of new blocks, which are pieces of data including financial details.
Verifying financial transactions
It is now possible to buy or sell crypto using exchanges such as Bitnomics, but all of those transactions must be verified and recorded on the blockchain. Depending on the consensus mechanism (a set of rules determining how transactions are being verified), the verification is done by miners or stakers.
These are actors that bring computational power, so the blockchain can continue to operate at normal parameters. According to experts at Bitnomics, this is a critical process, since it prevents “double spending”, or the usage of the same cryptocurrencies multiple times. However, miners and stakers are not working for free, which brings the discussion to blockchain rewards.
Bitcoin is using a Proof-of-Work consensus mechanism, which implies all miners verify the transactions, but only one will receive the reward once a new block is created. In order for that to happen, the miner must find a hash using a complex mathematical formula.
Projects like Ethereum are transitioning to Proof-of-Stake consensus, which is less energy-intensive and any person or entity wanting to verify transactions must lock funds (staking) on the blockchain. In doing so, they have “skin in the game” and it would be in their best interest to not allow double spending to occur.
With every new block created, a pre-determined amount of new tokens are being released into the system as rewards. This is still the way most blockchains operate, showing that alternatives to the traditional banking system exist can could function for an extended period.